Budget Your Bonus

Memo to Americans: As a group, for every $1,000 we bring in after taxes, we are saving $7, according to the Commerce Department. Why bring this up? Because if you’re anticipating an annual bonus this year, you should probably skip the cruise. Considering salary increases are barely keeping pace with inflation, no wonder white-collar workers are coveting those bonuses to help cover both wants and needs.

“The temptation to blow the whole wad on a junket to a sunny locale or on a big TV is enormous,” says Ellen Weiss, a spokeswoman for financial advisory firm Leonetti & Associates.

What principle should guide you as you allocate your bonus? “Put yourself in a better position with this money than you were before,” says financial planner Marc Sussman. Here’s how:

Identify Your Financial Priorities

How you order your financial priorities “really depends on where you are in life,” says Darrell Canby, president of Canby Financial Advisors. But for the average overspending American worker, these are the most important financial moves to consider when a bonus lands in your bank account:

• Pay Uncle Sam: Even though your employer withholds money from your bonus as legally required, you might owe additional state and federal taxes. Determine your tax liability before proceeding — no investment is better than the one that keeps you out of federal prison.

• Create or Bulk Up a Savings Account: Emergencies happen, but they get a lot more expensive if you have to pay for them with a credit card advance at 24 percent interest. Experts advise keeping at least three months’
income in the bank to avoid such credit card calamities.

• Eliminate Expensive Debt: Address any credit card balances in order of financial destructiveness. “If you have any credit card debt, apply the bonus to your highest balance or to the card with the highest interest rate,” says Cate Williams, vice president of financial literacy for nonprofit debt-counseling firm Money Management International.

• Invest in Retirement: Making an extra mortgage payment to move up your debt-free date is tempting, but it’s not always the best way to use your bonus. “I’d rather see people put money into retirement than pay off a mortgage,” Williams says. If you didn’t contribute enough to your 401k last year, be sure to do it this year. If you must, set aside your bonus in a savings account to allow for higher 401k payroll deductions.

Are you 50-plus and already contribute the maximum to your 401k? Consider using your bonus to make a catch-up contribution, a retirement investment vehicle designed for the typical Baby Boomer, who hasn’t put aside nearly enough. For the 2009 tax year, the 401k catch-up limit is $5,500; $5,000 for IRAs.